Going into the interview, I was focused on the following talking points:

Total bank reserves have skyrocketed over the past year, from roughly $50 billion to roughly $850 billion.

When we studied economics in school, we were usually taught that a big increase in reserves would eventually translate into big inflation.

However, that’s not true today, for two reasons: (1) short-term interest rates are effectively zero, and (2) the Fed can now pay interest on reserves. Those facts weaken / break the traditional link between reserves and inflationary pressures.

Some have wondered whether the excess reserves mean that banks are hoarding, rather than lending.

That’s not true either. Instead, the high level of reserves simply reflects the fact that the Fed has been a busy beaver, expanding its balance sheet by making loans and buying securities (i.e., credit easing). Banks might be hoarding or they might not; excess reserves don’t shed any light on the question.

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How confident are you that the Fed will actually hold the line on inflation by keeping the interest rate it pays on these excess reserves at a sufficiently high rate? Bernacke is going to be under incredible political and personal pressure (I presume he wants a second term as Fed Chairman) to lower that rate in the coming months.

Also, what happens to the interest itself. Does it get added to the excess reserves for each member bank that earns it?

Great stuff as always, both the interview and the original blog entry with the NY Fed paper. Thanks.

Very helpful, and probably the most important part of your talking points was a grammatical device — the slash — as in “Those facts weaken/break the traditional link between reserves and inflationary pressures.”

There’s a world of difference between weaken and break, because it’s the difference between an exit strategy that works, and one that almost works but leads to inflation and another recession. The National Journal online recently posed a related question trying to get a discussion about the slash.

Some commentators have fixated on the political implications of the slash — will the Fed buckle to political pressures? A reasonable concern, but economists should focus more on the substantive implications. We really need a more thorough discussion about the ability of the Fed — aside from political pressures — to use the paying of interest on reserves to control the flow of excess reserves into credit markets.

Thanks Ken and JD. I think we should break the question into three piece: mechanics, politics, and goals.

I think the ability to pay interest on reserves breaks the mechanical link between reserves and inflation. The one caveat, which applies to any new policy tool, is the possibiliity of mistakes.

As you both note, there’s a question of whether the Fed will be able to use the tool this way, or will fall under political pressure to allow greater inflation.

Finally, there’s the issue of the Fed’s own goals. My view is that Ben Bernanke is generally pretty hawkish on inflation (one implication of being an inflation targeter). However, both his writings (see, e.g, the speech about Japan several years ago) and those of other leading economists (see, e.g., Mankiw and Rogoff) indicate that there is a mainstream view that some inflation could be good as you try to extract yourself from a period of excessive debt.

I think the most interesting question is whether the Fed will decide at some point that it wants above-target inflation to help to economy. But I don’t have any answers on that front today.

Thanks. One quick comment. I understand the mainstream view, but I don’t agree with it. I understand the concept of easing up on the money supply during a deflationary or recessionary period, but that’s not quite the same thing. Inflation is what happens when you overdo it. Or if you do it deliberately on the theory that you pay back debt with dollars that are worth less than the ones you originally borrowed, you end up devaluating the dollar and, with it, the value of your savings and investments.

Also, it seems to me that the Fed has gotten much better over the last few decades in controlling money supply growth to avoid both excessive inflation. That’s good. But now we are in a brave new world using brand new tools that have not yet been tested and proven to be effective. Meanwhile, those massive excess reserves sitting in member banks’ accounts has got to be a huge temptation to the group of politicians that currently run our government, especially as the economy continues to struggle along with very high unemployment.

My question is: If the Fed is paying interest on the ‘loaned’ reserves would this not equate to negative interest on money loaned? And does that not suggest that new money given to the bank will not help the current economy suggestion a liquidity trap?